Plosser: Fed Too Vague With Guidance on Future Path of Rates

Tuesday, 12 Feb 2013 | 10:36 PM ETReuters

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Charles Plosser, President and CEO of the Federal Reserve Bank of Philadelphia

The Federal Reserve should be more explicit about the likely future path of interest rates, a top Fed official said on Tuesday, saying that while the central bank's recent changes to guidance on interest rates are a step in the right direction they do not go far enough.

The U.S. central bank in December promised to keep rates near zero until unemployment falls to 6.5 percent, as long as inflation does not threaten to rise above 2.5 percent. Its policy-setting panel, the Federal Open Market Committee, or FOMC, also said it would keep policy highly accommodative for a "considerable time" after the recovery strengthens, rather than tightening policy immediately.

"While this gives some indication that the Committee does not expect to tighten policy quickly after the thresholds are reached, the Committee is silent on how policy will actually be conducted," Charles Plosser, president of the Philadelphia Fed, said in remarks prepared for delivery to the Stanford Institute for Economic Policy Research.

"This vagueness runs counter to the theory that supports the use of this explicit form of forward guidance in the first place," Plosser said. The Fed would do better to adopt simple policy rules to guide expectations, he said, noting that he and his colleagues continue to explore such an option.

The U.S. central bank could also boost its policy effectiveness by identifying key economic variables beyond just inflation and unemployment and explaining its policy choices in terms of those variables.

Doing so would go a long way in educating the public about the Fed's intentions and boosting its credibility, both key to making its communications about the future path of rates an effective way to provide policy accommodation, Plosser said.

In September of last year, the central bank launched an open-ended bond-buying program, which it expanded in December after a separate stimulus effort ran its course.

It is currently buying $85 billion a month in government and mortgage-linked debt, and has said it plans to keep up the purchases until it sees a substantial improvement in the outlook for the U.S. labor market.

Plosser, an inflation hawk, has been an outspoken critic of the bank's prolonged near-zero interest rate policies, and on Tuesday he warned that promising to keep rates low for so long could spark a run-up in inflation.

"Will policymakers or the public be willing to tolerate the future inflation when it comes and believe that it is only temporary?" he asked.

Advocates of the Fed's new threshold-based policy have said that the thresholds contain an important safeguard against runaway inflation, because the Fed has committed to keeping rates low only if inflation expectations run no more than half a percentage point above its 2 percent target. The Fed could raise rates the moment inflation expectations top 2.5 percent, allowing the central bank to keep inflation well in check, they argue.

Plosser on Tuesday took issue with that view, calling the inflation safeguard only "partial insurance."

"The inflation threshold is formulated in terms of the central bank's outlook for inflation, which may be slow to deviate from the central bank's target until inflation and inflation expectations have already moved higher," he warned. "I would prefer that monetary policymakers be more transparent and adopt a systematic policy rule as a guide to policy."